Vertical Integration in Business

Small Business Application of Vertical Integration

Vertical integration in business refers to the process of gaining control over more steps of the productproductionstream. Whenever a business obtains or can greatly influence any one of these steps along the process of producing and selling a product, it is referred to as vertical integration.

Many of the Fortune 500 companies utilize this business technique to increase profitability and control the market for their products. A good example is Apple Corporation. Apple manages many of its manufacturing plants, controls the distribution system and owns many of itsretailoutlets. Furthermore, Apple creates its own software for its products.

Why would a company do this? Well, the primary reason is typically profit driven. By owning each of the steps, theprofitgenerated in each step under the traditional process is retained with the company. Secondly, by controlling the entire stream from raw resources to the final sale of the product, the company can ensure the proper quality and volume of the end product for sale to the consumer.

To fully understand vertical integration, I’ll explain the term in more detail and provide some modern day illustrations of its use. From there, I’ll explain how the volume issue restricts vertical integration in small business and how it should be applied. Finally, there arerisksinvolved in becoming vertically integrated and as a small business entrepreneur; you need to understand these risks and their respective impact in your business.

Business Definition and Illustrations

In the world of business, theproduction processis analogous to a water stream. The underground spring or the snow melt is referred to as the raw resources and the stream flows downward to the river. The final few yards of the stream is the final sale of the product to the end user. So at any point in the stream you can look upstream back towards the beginning or the raw resources or downstream towards the final disposition of the product to the consumer. When exercising vertical integration, any involvement from any point in the stream going upstream (backwards towards the raw resources) is often referred to as ‘backwards’ integration or ‘upstream’ integration. If you are going to control or own parts of the stream headed towards the consumer, this is referred to as ‘forward’ integration or ‘downstream’ integration. So remember these four terms (backwards, upstream or forward, downstream) as they are often used in conversation.

Vertical integration is the process of incorporating any one of the steps along the stream of production and sale to the consumer. If you owned a chain of retail outlets for any product or line of products and decide to invest or control the raw materials generation and skip over the production part, you are still backwards integrating. You do not necessarily have to purchase or control the prior step or the next downstream step in order to qualify as vertical integration. The key is that when a business tries to control either through purchasing or negotiating contractual relationships any step along the stream of production, it is vertically integrating its business.

Remember, there are two main reasons or justifications to vertically integrate. The first is profit driven and the second is control. The following sections explain these two main motives to vertically integrate.

Vertical Integration – Profit Driven

If you own a business, you often get the feeling that the vendor or supplier is making some good money off of you. You may purchase hundreds of a particular part or item and you just get the sense that the vendor does well from your book of business. You feel that if you could own that supplier or that step, you could make money off of yourself. This is the primary motive for vertical integration. But just how much profit is there? Well, to understand this, let’s work a simple example.

Suppose you own a toy store. Your biggest selling item is a model building kit of a car. You sell this kit to the consumer for $10 and you make a margin of $5. This means you are buying the kit from the manufacturer for $5. Now the manufacturer makes a profit too. It just so happens that his margin in manufacturing that kit is $1.25. But the manufacturer buys two materials to make the kit. The major material is the resin for the mold and the second material is the box purchased from the printer. The resin is made by a huge world-wide corporation that produces resins for all forms of plastic manufacturing. So we don’t really know how much profit the resin supplier makes. However, the printer sells the box to the manufacturer for 29 cents each. Their margin on the box is 13 cents. But they only imprint an image on the cardboard. They purchase this cardboard from a paper mill for 9 cents each. The paper mill has a margin of 3 cents for each cardboard box sold. They pay 3 cents to a company for the wood pulp. We have no clue how much the margin is for the wood pulp, but for this illustration, let’s just say a penny. So if you owned the entire process, that is full vertical integration, how much margin is there in that one kit? Let’s add it up.

Wood Pulp – $.01

Paper Mill – .03

Printer – .13

Resin Maker – Unknown

Kit Manufacturer – 1.25

Toy Store – 5.00

Total Margin $6.42

So out of the $10, $6.42 is the margin for all of the steps along the stream of production. This doesn’t include the amount the resin supplier makes either. So from a business perspective, you can see why any party along the production process would like to control the entire stream.

Vertical Integration – Control

I can’t count the number of times I have been disappointed by the quality or quantity of the items I have purchased in my lifetime. Every one of us has felt this way. Well imagine owning a business and your suppliers are either late with deliveries or sell you a lower quality part or service. If only you could control that situation so you could have the type of service or level of quality/quantity desired? Vertical integration addresses this secondary driving force of business operation. Let’s continue with the toy store example from above.

As the clerk in the store, your customers make comments and one of the comments is that the model kit is designed for teenagers and adults. They explain that if you added part numbers to the different pieces and had a set of easy to read directions you could expand the market to include kids from ages 8 up. Wow, what a great idea. But the kit manufacturing will not do it because they feel it isn’t justifiable. Well, you could just own the manufacturer and then make the change. You now get the product you desire because this is what the customer wants.

The control aspect of vertical integration isn’t just about making sure you get the product you want, it is includes:

Quantity or Volume

Quality of Materials or Construction

Gain Market Share to Reduce Supply to Competition

Reengineer the Product Faster to meet Changing Demand

Change the Flow (Speed) of Production

The key here is that as a business in one of the steps in the production stream gaining control whether upstream or downstream reduces risk for your business.

This all seems simple enough, but let’s remember, this really is easier in much larger production runs. This is because of the economy of scale involved. The example with the toy store is unrealistic. The cost and knowledge required is prohibitive. However, for well capitalized companies with significant market share they can manage the production stream with greater ease. The top four in the world are:

Apple

Proctor and Gamble

Cisco

Walmart

So how do they do it? Let’s look at some examples:

Walmart – all of the large grocery chains use their own private label as a competitive product on the store shelf. Walmart uses the ‘Great Value’ brand as its private label. In the home entertainment industry, Walmart purchased Vudu, an on-line movie streaming company back in 2010.

Proctor and Gamble – when P&G started out in the late 1800’s they had one plant in the U.S. Located in Cincinnati, P&G expanded to Kansas City and to New York. In addition it starting the corporate philosophy of vertical integration in 1901 forming a company called Buckeye which produced cottonseed oil. In those days, cottonseed oil was essential in making soap. In 1903 P&G purchased Schultz & Company out of Ohio to begin its entry into the laundry soap powder business (this example is more in line with horizontal integration discussed in a different article).

Coca-Cola – Coke started out in 1886 in a single pharmacy in Georgia. A good day was 10 servings sold. Today, Coca-Cola has over 500 different brands and serves 1.7 Billion drinks per day. To cut out the middle man, Coca-Cola purchased the independent bottlers that controlled local markets throughout the United States.

The value with vertical integration is actually the economy of scale involved. Do you think a small soft drink retailer can purchase a manufacturing plant to sole source its preferred brand? Very unlikely, so volume is essential to vertical integration’s success. If this is true, how can small business vertically integrate? Well, it may not be simple, but it is doable. The next section explains how to apply vertical integration in small business.

Application in Small Business

In small business, economy of scale does exist, but you should only go after an economy of scale that mirrors your business. Suppose you are a licensed mechanical contractor. You install heating and A/C systems in new construction and as a service company. The only brand of systems you work with is Trane. Now you are interested in getting vertical in your business. Well, I can assure you that you cannot buy the Trane Corporation. Trane is a subsidiary of Ingersoll Rand, a publically traded corporation on the New York Stock Exchange.

I know, DARN! Well so much for vertical integration. Well, not so fast. There are other aspects of your business that can allow you to go vertical. In addition to installing the units, you install the ductwork in the houses. Currently you farm out the assembly of the metal work to a local metal fabricator. He basically purchases sheets of tin and uses a bender (a large table with a huge bar and straight edge for leverage in bending aluminum and tin) to form your duct work in accordance with your measurements. In addition, he has a guy that brazes the joints together and VOIL’A, you have ductwork.

Now we have opportunity. This part is doable. How else can we expand the vertical integration? Well, let’s look at the customer end of the situation. Is the sale the end of the relationship? Actually no, often the customer needs someone to come out twice a year and conduct routine maintenance. Why not you? Remember the term ‘Forward Integration’? After all, you installed the system; why pass off the profits related to service and maintenance.

There are still other avenues for vertical integration. Let’s assume that you now run 20 crews in your mechanical company and purchase over a $1 million per year in copper tubing from a local metal supplier. Now it is time to research the possibility of buying directly from the manufacturer of copper tubing. You are effectively knocking out the distributor (middleman).

In a real life example that I was a part of occurred with a residential contractor. He was building more than 13 homes per year and kept a brick layer busy pretty much 50% of the time. The brick mason was exhausted by having to not only run the jobs but having to go out and do marketing, managing the financials, and having the financial depth to pay all the various bills. So the contractor created apartnershiprelationship with the brick mason and brought the entire crew into the company. He then went to a few of his closet fellow contractors and farmed out the brick mason to them to fill the down time periods.

Notice how the contractor is using ‘Upstream Integration’ to gain control over the brick mason and bring those profits in house?

To apply vertical integration in small business, don’t leverage the economy of scale too much. If that brick mason was only used by the contractor 20% of the time, I believe the contractor would over extend his reach because it will be difficult to find work for the open 80% time frame. So as the provider of goods or services to your company he has more and more of his capacity of operations consumed by you, the greater the likelihood of success in integrating his operation with yours.

I’ve seen in other businesses too. Farmer markets will often control the sources of the vegetables or fruit by growing the produce themselves. In one case that I witnessed, the stand sold baked fruit desert pies. When the volume had reached several dozen per day, the owner decided to control the quality and quantity by baking them in one of his customer’s restaurants. To compliment this, he used his own fruit from the stand!

So vertical integration is possible in small business, but you need to think it through. The best way is to write it down and identify the possible positive attributes and the drawbacks. Clearly document how this can go wrong. There are a lot of issues related to the various risks involved and finally there are economic concerns to address too.

Issues Related to Risk and Economics

There are several risks involved when a business vertically integrates. The highest risk factor relates directly to the primary reason to integrate. When a business expands its scope along the production stream it also increases its reliance on the particular product. Any change in consumer purchasing habits affects all stages of production from start to finish. If your business owns several of these stages, each stage is impacted in a similar fashion. When you leverage the profitability, you also leverage the risk associated with earning a profit.

This is a critical risk factor. Let’s go back to my contractor example. If the sales of new homes go down 20%, the workload for the brick mason also goes down. It is actually worse, because half of the time the brick mason is farmed out, this means that the other contractors are probably feeling the same pain. Therefore, the workload from these sources decreased 20% too. In effect, the leverage aspect works both ways.

In large scale integration, the risk associated with the lack of knowledge about the particular nuances associated with one of the stages is not as big of a problem. For large companies, they can easily hire the right people or even better people to solve the problem. But in small business, this is not as easily done as someone may believe. For example, I used the mechanical contractor bringing the ductwork fabrication in house. Well, one of the skills needed is someone to braze the parts together. It isn’t like there are 50 people available in the market that have this skill. And those with this skill are usually already employed and doing well. So there is no incentive for the better welders to come work for this mechanical contractor. Often, when a small business takes these steps the management team fails to recognize the business dynamics involved with expansion. Sometimes so much focus is aimed at the new segment; the primary business purpose falters.

So, do you or don’t you vertically integrate? The best answer is if you have the financial resources (the economic power) and the appropriate economy of scale, it can be considered. However, there are other tools available to the small business owner to exercise that will create a similar outcome. These include forming partnerships with your suppliers, generatingcontractualarrangements that are enforceable and many other tools.

This article introduces the reader to the term ‘Vertical Integration’ and how it works in small business. If used and implemented with proper financial backing and an appropriate economy of scale, a business can vertically integrate with successful results. Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.

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I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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